Are Ethical Investment Funds Higher Risk Than Other Similar Funds?

Summary:A 'small universe' of potential shares in which an
ethical investment fund manager can invest can really hold back his (or
her) ability to deliver both returns and diversification. We discuss
the issue here...

The nature of investing with your morals has obvious side
effects. One of these is that the risks associated with ethical
investment funds are higher. There are several reasons for this which
shall be explained below.

Firstly, it may seem obvious to comment on, but is often
overlooked that fund managers might have a very small number of
potential investments to choose from. If the criteria of the fund is
applied rigidly, the fund manager may only have a very small number of
approved potential companies. This is known as a small universe of
potential shares.

The companies available to a fund manager may be from only very
selected industries. This lack of potential companies and sectors can
make the returns of a fund more volatile than might otherwise be the
case. These funds can also become less and less diversified.

This 'small universe' is something that happens in many walks of
life. For example, many Presidents and Prime Ministers suffer from a
'lack of talent' from which to choose when it comes to filling positions
in their cabinet.

As an investor, we may wish to invest with our hearts and hope for
reasonable long-term results, but in reality we are all emotional
creatures. It is very easy for us as individuals to be forced to sell
units in a fund because we do not like it's additional volatility.

This additional volatility can take many forms. For example, bad
news published in the financial press about an industry - solar power,
for example - could have quite an impact on all environmental or ethical
investment funds. With underlying share prices suffering, the funds
investing in these companies may all suffer.

Therefore, the combination can lead to most funds creating very
similar portfolios, which generate very similar annual returns and are
difficult to market because they appear to be indistinguishable from the
competition.

This can make managing money very difficult for the fund manager.
If every time asset prices are doing well, investors sell whilst they
can - knowing or expecting there to be bad times that follow - it can
become difficult to maintain the balance of a portfolio.

Though this is a different potential problem, the increasing
numbers of ethical investment funds offer an investor many different
choices. It is now possible to select from ethical funds aimed towards
income or growth and have a range of risk profiles and asset mixes.
However, if the rules are too tight on the fund manager as to what does
and does not qualify for investment, this can force the fund to be very
concentrated on just a few companies that fit the exact criteria
required.

With such a wide range of funds, private investors will almost certainly find it difficult to
make decisions
that finds a fund that invests in just the right way for them - even though such an ethical fund may exist.

These funds are often now termed in relation to 'shades of
green'. Those funds using a positive selection criteria and hoping to
encourage better corporate behaviour are often referred to as lighter
green. Ethical investment funds which exclude companies whose corporate
behaviour is not approved of are usually termed as darker green.